Abstract

The breakdown of the Bretton Woods system and the adoption of generalized floating exchange rates ushered in a new era of exchange rate volatility and uncertainty. This increased volatility led economists to search for economic models able to describe observed exchange rate behaviour. In chapter 2 we propose more general STAR transition functions which encompass both threshold non-linearity and asymmetric effects. Our framework allows for a gradual adjustment from one regime to another, and considers threshold effects by encompassing other existing models, such as TAR models. We apply our methodology to three different exchange rate data-sets, one for developing countries, and official nominal exchange rates, the second emerging market economies using black market exchange rates and the third for OECD economies.
The large appreciation and depreciation of the dollar in the 1980s stimulate an exciting academic debate on using unit root tests for structural break. We propose a model which is the natural extension of the behavioural equilibrium exchange rate (BEER) model. We then propose more general smooth transition (STR) functions, which are able to capture structural changes along the equilibrium path, and are consistent with our economic model. Our framework allows for a gradual adjustment between regimes and considers under- and/or over-valued exchange rate adjustment. We apply our methodology to the monthly and quarterly nominal exchange rates for seventeen and twenty OECD economies and construct bilateral CPI-based real exchange rates against the U.S. dollar and the German mark.
The investigation of chapter 4 focuses on non-linear forecasts to testing exchange rate models by examining microstructure - order flow. The basic hypothesis is that if order flow includes heterogeneous beliefs and the information contained in them, heterogenous customer order flow can have forecasting power for exchange rates. Using statistical and economic evaluation, we quantify the role that, when the information is lagged or simultaneously released to all market participants, the key micro level price determinants - order flows is impounded into price. The results indicate: 1) order flow with non-linear consideration lead to considerable and statistically significant improvements compared to the random walk model; and 2) order flow is a powerful predictor of the exchange rate movement in an out-of-sample exercise, on the basis of economic value criteria such as Sharpe ratio and performance fees implied by utility calculations.